Tuesday, April 12, 2011

If Not For Egypt, Where Would Oil Be?

Other than that, Mrs. Lincoln, how did you like the play?

You can easily paraphrase that snarky twisted 150 year old question into a commentary on February oil prices.If not for the Egyptian uprising, we would probably be looking at cheaper prices for gasoline and diesel this month. It wouldn’t represent the new normal, but it would be a welcome interlude before the spring rally begins.

Gasoline prices have more or less drifted aimlessly in the last 30 days, hanging between $3.09-$3.12 gal nationally. Drift may be the most appropriate verb for describing the direction motor fuel prices pursue in the first half of February. But I’m more convinced than ever that we’ll see considerably higher prices between the 83rdannual Academy Awards and the mostly cheesy blockbusters that debut before Memorial Day weekend.

And no, the red carpet for higher spring fuel prices does not depend on the ongoing unrest in Egypt and other North African countries. Those events merit some mention at this point, but equally compelling cases can be made for an oil price advance tied to Egyptian chaos, or an oil price retreat tied to the same events.

But first, let’s revisit the numbers. Americans spent $31.6-billion on gasoline in January 2011. Believe it or not, that represented a small drop from December expenses, thanks mostly to the predictably poor demand that comes with miserable God-forsaken depressingly horrid weather that has blasted us in this infernal winter (there, I feel better now, after venting). We’ll probably spend about $32-billion in February on motor fuel. This is not a typical February. One can usually count on slumping prices in January and February, similar to the way one can depend on awful movie releases (think Ashton Kutcher).

These are not meaningless costs. As recently as 2009, Americans paid less than $21-billion for their January allotment of gasoline.

What would monthly costs look like if Americans have to pay the $4 gal or $5 gal numbers that were predicted by former Shell president John Hofmeister?A $4 gal price in May might yield a monthly cost of about $48-billion. A $5 gal price would push monthly gasoline expenses to the threshold of $60-billion.

I don’t think we’ll see 2011 or 2012 pricing points that will push us to $50-billion or $60-billion. But I do believe that we’ll threaten $40-billion this spring.

Egypt & Oil

Egypt is not a major oil producer and doesn’t export much crude, and yet we’re paying more for our winter gasoline, heating oil, diesel and jet fuel largely because of the ongoing crisis. Why?

For more than twenty years, oil markets have operated within the constraints of “just-in-time” inventory management. For the last ten days, however, market prices have been determined by a “just-in-case” dynamic.

Futures and options’ sessions have been lively, but sellers that might typically act as circuit breakers in oil price rallies have been absent. With Egypt in turmoil, it is simply not safe to be short. The chances of disruptions spreading eastward into the Gulf Cooperation Countries (Saudi Arabia, Kuwait, Bahrain, Qatar, The United Arab Emirates, and Oman) appear remote. Every one thousand barrel crude oil futures’ contract is worth a little less than $100,000 as I write this. The most intrepid of traders would have to cut themselves off from electronic media to feel safe about selling oil.

Here is an incredible comparison that underscores just how drastically the oil market has changed since the last time there was similar uncertainty in the world. I looked back at futures & options data for March 2003 when the Iraqi War began. The contrast between the structure and size of oil markets then and now is quite stunning.

Current participation in NYMEX futures and options is about three-to-five times higher than it was eight years ago. Open interest in crude—the number of positions held by both buyers and sellers -- is about 2.6-million contracts, compared to less than 550,000 contracts in March 2003. Combined open interest for gasoline and heating oil is above 714,000 currently, compared to just 247,000 contracts on the threshold of the war.

For the layman, the aforementioned numbers might not mean much. But put simply: physical oil demand is perhaps 10% higher than it was in 2003, but financial participation from banks, hedge funds, commodity pools, index funds, algorithmic traders et al. has increased by 300% or more. Oil futures & options are now a major asset class, and the amount of money at risk when events break a certain way is exponentially higher than it was in 2003.

But an even closer look reveals some more stunning changes. The weeks ahead of the Iraqi War saw speculative sellers outnumber buyers. The day before U.S. military made its first advances, speculative shorts outnumbered longs by about 32,700 contracts, representing a bias of money bet on lower prices that represented 32.7-million bbl of physical crude.

The oil trading community has regularly bet on higher price outcomes for about five years. More money coming in to the commodities markets means more bids for oil. But the scale of the market has increased so that there is much more money at risk now than there was ahead of the Iraqi War. I counted speculative short positions representing about 119-million bbl in WTI; 11-million bbl in RBOB; and 34-million bbl in heating oil. It is unlikely that any of the financial companies or trading houses took those positions and remotely considered that the Arab world could be in upheaval in February.

One other noisy problem. Every day, most Americans wake up and turn on their TV and hear about the price of crude. In almost all cases, the price that’s quoted represents West Texas Intermediate crude, which is the standard contract.This “WTI” benchmark has been accurately portrayed by analysts smarter than I as the “broken benchmark.” It reflects landlocked North American crude that can’t move to the various U.S. coasts. American gasoline, diesel, and jet fuel prices have moved more in response to global crudes, such as North Sea Brent blend. There are a number of sweet offshore blends trading well above $100 bbl and those are the currently relevant numbers for U.S. wholesale and retail prices.

(By the way, this will change. However, the change doesn’t come for at least two years when some pipelines that can bring North American crude to the Gulf Coast should be finished. WTI will be much more relevant in 2013.)

Even without Egyptian chaos, U.S. gasoline rallies this spring

Without the Egyptian backdrop, it’s likely that we would be looking at WTI prices in the $80’s with wholesale gasoline about 20-25cts gal lower than we find it in early February. That would represent the typical midwinter break ahead of U.S. refinery turnaround season.

The issue now is whether overseas uncertainty will simmer and keep sellers out of the market before extensive U.S. refinery maintenance begins. Every year, U.S. refiners perform routine or special maintenance, and they choose to do so after peak winter fuels’ demand, and before the summer driving season. In other words, you can expect to see lots of orange cones and additional hard hats at U.S. refineries in the next 90 days.

All of this work must be accomplished as pipelines and terminal operators purge the supply system from winter gasoline (which needs to be volatile because of cold temperatures) to spring/summer gasoline, which requires much lower vapor pressure.

That’s one of the reasons why I haven’t mentioned this week’s gasoline inventories, which are at their highest level since Driving Miss Daisy was Oscar buzz. Yes, we have 236-millon barrels of gasoline in U.S. storage, but much of it is perishable, and represents what I call “brown banana gasoline.” It needs to be flushed and replaced with non-perishable spring/summer fuel.

My best guess is that U.S. refinery runs will scrape bottom in late February or early March, and thereby incite a 2011 round of “petronoia” that will lift nationwide retail prices to $3.50-$3.75 gal.